Max Pain – A Key Trading Concept

First off, please note that this post is about the point of maximum pain one can endure in a trading/investment position. It is not about the awful 2008 Mark Wahlberg movie with a similar name (Max Payne).

The concept of max pain should be familiar to anyone who has ever been forced to “puke” a position. We traders use the word “puke” because it’s how you feel when you trade out of the losing position – it’s a long that you have to sell because it’s making you sick with continued price declines, or a short that you have to cover because it keeps rallying against you and giving you a sinking feeling in your stomach. You can’t take the pain anymore, so you cut the position loose. Anyway, when you eventually puke a position due to your max-pain threshold, you know what happens: the stock reverses in short order, doubling the angst you feel. If you sold it, it marks the bottom. If you covered a short, it marks the top. If you have no idea what I’m talking about, bless you – you are a gifted and/or lucky trader.

Last week, I noticed some wild intraday action in JC Penney ($JCP – no positions):

JCP- Sep 19th, 2012

Herb Greenberg has been all over this stock for most of this year, and it was his Stocktwits message on it that caught my eye:

Now, before I continue, I want to explain that although I have disagreed with Herb Greenberg in the past, the purpose of this post is positively NOT to make fun of Herb. This is a trading concept that any experienced trader is probably already familiar with, and I emailed Herb privately to talk with him about writing this post and to explain that I am not mocking him. Continuing…

So if you look at the timestamp of Herb’s tweet, and you look at the intraday chart, you’ll notice the very definition of “max pain” – also known as “capitulation.” Herb had, a few months ago, turned bearish on $JCP, and, given the price action, was finally thinking about capitulating on his bearish outlook (which itself was a capitulation on his “stock of the year” call, but we’ll get to that in a minute). I don’t know if Herb actually had a position in JCP – I’m guessing not, because it would be a conflict of interest for him to trade the stocks he is writing about – but in any case, Herb’s calls are his reputation: so even if he didn’t have real money on the line, I think his “stake” in getting his JC Penney calls (and all of his other calls) correct is quite strong. I mention “stake” because you don’t feel the pain of losing something (money, reputation, etc) if you have nothing on the line – this is a concept most traders won’t realize if they’re not trading real money or, in Herb’s case, real reputation.

The timestamp on Herb’s “flip-flopping” tweet marked the very top of $JCP’s ascent that day, and the stock, having shaken Herb out of his short, doubled his pain as it quickly reversed to the tune of a more-than-6% drop in 10 minutes. Here’s the interesting trade: Herb felt the nut-kick from the market – which seemed to be taunting him for giving up on his bearish call. But Herb wasn’t stubborn – he didn’t keep the stock on his quote monitor, complaining about getting shaken out of his short, watching the stock go lower and lower in accordance with his now-abandoned-due-to-max-pain thesis and missing the move – instead, he quickly capitulated on his capitulation (for those keeping score: making him bearish on the stock again:)

You can see what happened to the stock in the days since – getting back into the trade, instead of being stubborn and moping about regret, worked so far:

Now, there are a lot of natural questions that this post might trigger in readers, such as:

“Kid Dynamite, are you saying we should just chase the market’s momentum? It seems like Herb was just buying when it was up and selling when it was down.”

I actually wrote a post about the key difference between momentum and mean reversion strategies several years ago. The cliff notes are that with the momentum strategy, you get whipsawed a lot more (stopped out of a lot more trades), but you have fat positive tails on your trade returns. Mean reversion (which is what comes natural to most people: buy low, sell high) has the opposite traits, generally. So what does that have to do with this post? The continued momentum against one’s position is what triggers the max-pain reaction in the opposite direction. The ability to avoid regret and put on new trades, even in the same name that just kicked you in the nuts, is a great skill for traders to “learn” – hence my illustration of Herb’s rapid capitulation of his own capitulation. Confused yet?

another reasonable question would be:

“Kid Dynamite, The Market doesn’t give a crap about you, me, Herb Greenberg or anyone else. Are you actually insinuating that The Market moved just to screw Herb over?”

No, of course not – I’m simply trying to illustrate the psychology behind the thresholds of pain one can take while holding losing positions, and how, strange as it may seem, we are often very “good” at giving up at the worst time. Of course, this makes sense: the reason JCP rallied sharply last week was because there were lots of people giving up on their short calls – not just Herb Greenberg! Once everyone gives up on their short and buys the stock, the buying is done and the stock is free to go lower. It’s basic contrarian theory: when everyone is bullish, there’s no one left to buy, so prices go down, and when everyone is bearish, there’s no one left to sell, so prices go up.

Changing gears again, and stepping back into the JCP time machine:

We need to step back in time a bit and look at the the full Herb-JCP picture, because there’s even more max pain involved. Herb went out on JCP as one of his 2012 picks of the year from the long side, before the calendar year even started. The stock had a rocky road:

JCP – YTD

Herb’s first max pain call was his capitulation on this long trade, which, almost perfectly, marked the bottom for JCP thus far this year. Herb made this call on July 16th, calling JCP CEO Ron Johnson a candidate for “Worst CEOs of 2012,” and explaining why he was no longer on the bull-train with JC Penney.

I wrote this post out of sequential time order, starting with last week’s price action and trading calls and then backing up to earlier in the year. Think of it as the Memento of blog posts, I guess. I didn’t want to make the post a top to bottom chronicle of how great a contrarian indicator Herb Greenberg has been in JCP this year – because as I noted, the point is positively not to mock Herb – it’s to illustrate this clearly documented graphical exhibition of the trading concept of max pain. JCP tormented Herb all year, causing him to capitulate on both a long call and a subsequent short call at clear max pain thresholds, which are rarely presented quite this clearly for illustrative purposes.

If you’re a trader trading real money who has never experienced this max-pain phenomenon, well, congratulations – I think the more talented one is as a trader, the less one is bothered by these max-pain reversal points. I tried to dwell on this point in the post, but I’m not sure it came across well: a good trader, upon puking a stock at the lows only to see it turn around, might buy it back if his initial thesis was still sound. A bad trader, however, whines about how unlucky he was, how the HFT Algos forced him to do it, how markets are manipulated, or any one of another armful of excuses.

EDIT: comment from Herb:

“I was having fun w/those tweets but they definitely serve as a lesson for investors who trade. emotion vs. reality.”

Herb’s comment helps me clarify my message in this post: when you’re trading real money, emotion naturally comes into play. The best traders will learn to minimize this emotive effect. The more you are able to remove emotion from the equation, the more likely you are to be successful as a trader.

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